Monday, August 31, 2009

I am impressed with markets' resilience in the face of China's 6.7% sell-off overnight. Aside from Hong-Kong, global equity markets have shrugged-off the new Chinese bear market with a disinterested grunt. Here in Canada, banks are mostly higher on the day despite a 1.5% drop in the index, while the U.S. banking sector continues to consolidate sideways, off just 0.75% today.

4:30pm update: Volume was lower across the board, so institutions are sitting on their hands.

The clear losers from the China sell-off are commodities, with oil down $3 to below $70, and copper off 12 cents at 2.83. Oil is at critical support from a trend-line going back to late April (see chart of DBO below), while copper has reversed off important resistance at the 61.8% Fibonacci retracement level of $3.00 (See copper Fibs below).

DBO Oil Fund ETF
Source: Stockcharts.com

Copper Market with Fibonacci Levels
Source: Stockcharts.com

Commodity currencies, like the CAD and AUD sold off substantially earlier in the day but have since rebounded, especially against the Yen. The CAD/USD found support from its 50 day moving average slightly below 90 in the morning, and is likely to test its multi-week trend-line (currently at ~89) before finding further direction.

Canadian Dollar ETF
Source: Stockcharts.com

Canadian Dollar ETF / Japanese Yen ETF Ratio
Souce: Stockcharts.com

We monitor the Asian Dollar Index for macroeconomic strength in that region. The index has been consolidating for several weeks in a pennant formation which is likely to break up or down in the next few days. Given the ADXY's strength in the face of China's panic sell-off overnight, an upside breakout is more likely. On an upward break-out, there is resistance at the previous high (~109) which, if broken, would signal further emerging market strength, led by Asia.

Asian Dollar Index
Source: Bloomberg

Bonds are confirming the bearish story in commodities, with long-term Treasuries rallying to resistance for the second time in 2 days.

20+ Year US Treasury Bond ETF
Source: Stockcharts.com

The 10-year TIPS breakeven rate, a measure of bond traders' future inflation expectations, is testing key support today, suggesting that traders are skeptical of current commodity strength.

10-Year TIPS Breakeven Rate
Source: Bloomberg

10-year yields have also been consolidating in a pennant formation; a break of 3.25% would indicate a major change in the trend of 10-year rates, at which point equity bulls would necessarily be put on the defensive.

10-Year US Bond Yield
Source: Bloomberg

Gold continues to consolidate in its intermediate-term pennant structure forming the right shoulder of what looks like a huge inverse head and shoulders formation. This structure suggests higher prices lie ahead. However, there are two clear resistance levels that must be breached before we can celebrate gold's new up-trend. Using the GLD ETF chart, the first resistance line sits at ~$94.25, with the longer-term line at ~$95.50. These are important levels to watch. A breach of the upper resistance line would suggest a re-test of the previous highs near $99, with potential for a test of it's all-time high of $100.44.

GLD US Gold ETF
Source: Stockcharts

Meanwhile, credit spreads seem impervious to the macro fragility implied by the charts above. CDS spreads in Europe and the U.S. continue to consolidate near their intermediate-term lows.

In conclusion, several important macro indicators are testing important resistance and support levels, but the pennant-shaped consolidation patterns suggest trend-continuation at this time. As such, stock markets are likely to move sideways in the short-term, with the potential for a short-term correction driven by commodity weakness. The most likely intermediate-term direction for stocks is up, with the potential for the S&P to move as high as 1200 before we begin wave 3 down. Should 980 be taken out on the S&P, we would look for a more immediate, steeper decline to ensue.

For longer-term context, I leave you with Doug Short's most recent chart of the Three Mega Bear Markets.

Sunday, August 23, 2009

Merrill Lynch posted the results of its most recent Survey of Fund Managers for August this morning. The survey covered 204 fund managers in 80 countries who control $554 billion in assets, and the data dispels the myth of excess cash on the sidelines.

Barry Ritholtz at ritholtz.com summarized the findings. Note that U.S. markets peaked in September 2007:

• Cash balances plunge to 3.5%, lowest since July'07;

• Highest equity allocation (34% from 7%) since Oct'07;

• Bond allocation (-28% from -12%) lowest since April'07;

• Tech (28%) is the most favored sector everywhere.

Barry concluded, 'While I keep hearing about cash on the sidelines, the professionals seem to be "All In."'

As an addendum to the Merrill Lynch survey (full release pasted below), please see the attached chart of US commercial paper and Money Market assets. The chart was originally posted by WallStreetExaminer.com using US Federal Reserve data. Annotations in red are my own.

Conclusion: Investable Money Market fund assets are no higher than at the peak of markets in September 2007. Retail holdings of MM funds have now retraced to the levels of Sept 2007. The spike in Institutional MM assets from Sept 2007 is exactly equivalent to the drop in CP assets over the same time period, offering compelling evidence that companies have simply moved treasury working capital out of CP and into IMM funds. This is NOT parked investment capital, and is unlikely to find its way into stocks.

Investors appear to be exactly as fully invested as they were in September 2007, at the peak of the bull market. This dovetails nicely with the Merrill survey.

That said, the Primary Dealers are swimming in reserves. Liquidity parked in Securities Open Market Accounts at Primary Dealers is also back at September 2007 levels (See PD Liquidity Chart). If the money-centre banks decided to leverage these reserves into the system, they could single-handedly push stocks, commodities and corporate bonds higher. It remains to be seen whether banks will hold these as reserves against 'Level III' assets on their balance sheets or put it to work speculating.

NEW YORK and LONDON, Aug. 19 /PRNewswire/ -- Investor optimism about the global economy has soared to its highest level in nearly six years, with portfolio managers putting their cash back into equity markets, according to the Merrill Lynch Survey of Fund Managers for August.

A net 75 percent of survey respondents believe the world economy will strengthen in the coming 12 months, the highest reading since November 2003 and up from 63 percent in July. Confidence about corporate health is at its highest since January 2004. A net 70 percent of the panel respondents expect global corporate profits to rise in the coming year, up from 51 percent last month.

August's survey shows that investors are matching their sentiment with action, by putting cash to work. Average cash balances have fallen to 3.5 percent from 4.7 percent in July, their lowest level since July 2007. Equity allocations have risen sharply month-over-month with a net 34 percent of respondents overweight the asset class, up from a net 7 percent in July. Merrill Lynch's Risk and Liquidity Indicator, a measure of risk appetite, has risen to 41, the highest in two years.

"Strong optimism in August represents a big turnaround from the apocalyptic bearishness of March. And yet with four out of five investors predicting below trend growth for the year ahead, a nagging lack of conviction about the durability of the recovery remains," said Michael Hartnett, chief global equities strategist at Banc of America Securities-Merrill Lynch Research. "The equity rally has been narrowly led by China and tech stocks. We have yet to see investors fully embrace cyclical regions such as Japan or Europe, or Western bank stocks."

Lasting recovery requires greater balance

Global emerging markets, led by China, and technology stocks are the strongest engines behind the early recovery. Investors would rather be overweight emerging markets than any other region, and by some distance. A net 33 percent of the panel prefers to overweight emerging markets while investor consensus is to remain underweight the U.S., the eurozone, the U.K. and Japan.

Technology remains the number one sector, with 28 percent of the global panel overweight the industry. Industrials and Materials lag with global fund managers holding 11 percent and 12 percent overweight positions respectively.

Further behind are Banks. Global fund managers remain concerned about the sector, holding a 10 percent underweight position. In contrast, investors within emerging markets are positive about Banks with a net 17 percent of fund managers in the regional survey overweight bank stocks.

Some of these sectoral and regional imbalances are starting to erode, however. Global fund managers have scaled back their underweight positions in bank stocks from 20 percent in July. Industrials and Materials have recovered from underweight positions one month ago. Emerging markets are less popular than in July when 48 percent of the panel most wanted to overweight the region. And Europe is a lot less unpopular. In July, a net 30 percent of respondents wanted to underweight the eurozone. That figure has dropped to just 2 percent in August.

Improved outlook for Europe, but investors drag their feet

Within Europe, fund managers appear as excited about the outlook as their global colleagues. A net 66 percent of respondents to the regional survey expect the European economy to improve in the coming year, up from a net 34 percent in July.

The net percentage expecting earnings per share to rise nearly trebled, reaching 62 compared with a net 23 percent a month ago. Investors in the region took an overweight position in Basic Resources, a cyclical sector, and radically scaled back their overweight position in Pharmaceuticals, a defensive sector.

In contrast to global respondents, those in Europe have failed to inject new money. "European growth optimism has finally caught up with other regions, but fund managers have yet to fully act on this and cash levels have actually increased and overall sector conviction is near record lows," said Patrik Schowitz, European equity strategist at Banc of America Securities-Merrill Lynch Research.

Survey of Fund Managers

A total of 204 fund managers, managing a total of US$554 billion, participated in the global survey from 7 August to 12 August. A total of 177 managers, managing US$370 billion, participated in the regional surveys. The survey was conducted by Banc of America Securities - Merrill Lynch Research with the help of market research company TNS. Through its international network in more than 50 countries, TNS provides market information services in over 80 countries to national and multi-national organizations. It is ranked as the fourth-largest market information group in the world.

Saturday, August 22, 2009

Those tortured souls who have thus far clung faithfully to the rules of capitalism, finance and economics they learned in business school have surely been disillusioned by the markets' most recent break to new highs. Like children who have finally relinquished the corporeal reality of Santa Claus, these poor souls may be searching for new rules and theories to legitimize their discipline. After all, we can't all be technical analysts, can we? Someone has to take the first step, buy the first shares in order to break a stock to new highs and trigger the technical feeding frenzy!

Those looking for new meaning in the markets may have already discovered the refreshing empiricism of behavioral economics to fill the theoretical void left from the now incontrovertible refutation of the efficient markets hypothesis and CAPM. Surely everyone now realizes that the only factors that impact asset prices are liquidity and sentiment. The former is measurable, though definitions vary considerably. Volume, cash on the sidelines, monetary growth and velocity, reserves held at Primary Dealers and foreign capital flows all contribute to a predictive measurement of liquidity. Sentiment is more esoteric, but can still be measured using surveys and studies of actual trader commitments. Of course, sentiment is only really predictive of market direction when it reaches extreme levels; extreme levels of bullish sentiment often signal important market tops (who is left on to buy more stock?), while extreme bearishness often signals market bottoms (who is left to sell stocks?).

James Montier of Societe Generale is perhaps the most widely followed practitioner of behavioral finance (as opposed to researchers and theorists like Thaler, Kahneman, Tversky and Smith). A recent missive of his was particularly interesting, as it described the results of a remarkable experiment in behavioral finance that may have some bearing on the present market environment.

From the report:

"As the US market is now back at fair value [950 at time of writing], I've been pondering what could drive the market higher. Jeremy Grantham provides some answers in his latest missive to clients. He argues that "the greatest monetary and fiscal stimulus by far in US history" coupled with a "super colossal dose of moral hazard" could generate a stock market rally "far in excess of anything justified by…economic fundamentals". This viewpoint receives support from the latest finding from experimental economics. The evidence from this field shows that even amongst the normally well behaved 'experienced' subjects, a very large liquidity shock can reignite a bubble!"

Mr. Montier then goes on to describe the results of an important study involving experimental markets (in which participants trade an equity-like asset against one another in a simulation), which suggests that experience helps to prevent bubbles - but that it takes more than one experience to change behavior. Explains Montier, "The first time people play the game, they create a massive bubble (like the dot.com bubble). The second time people play the game, they create yet another bubble. However, this seems to be driven by overconfidence that this time they will get out before the top. The third time subjects encounter the game, they generally end up with prices close to fundamental value."

To reiterate, experimental results indicate that even subjects who have experienced the euphoria and losses from the creation and eventual implosion of one market bubble will almost always go on to create another bubble under similar conditions. When surveyed after the fact to explain why they made the same mistake a second time, subjects overwhelmingly indicated that they were confident they could get out ahead of the crash. When subjects realized after their second failed attempt that they were unlikely to outsmart the bubble, they finally refused to create a bubble on their third encounter with the game.

Of particular interest in today's environment, the experimenters took the simulation one step further to discover whether, under the right conditions, they could cause the same experienced participants to create yet another bubble. It turns out that all it takes to re-ignite another bubble among experienced game participants is a massive liquidity injection. To wit, "new research by the godfather of experimental economics, Vernon Smith, shows that it is possible to reignite bubbles even amongst the normally staid and well behaved subjects who have played multiple bubble games. The key to this rekindling is massive liquidity creation. In fact, in his experiments Smith doubled the amount of liquidity available."

Why is this relevant to today's market situation? For starters, the Fed has essentially doubled the monetary base from $850 billion to $1.7 trillion in the past 12 months. Keep in mind that, given the leverage in the system ($~2 trillion in money supplied by the Fed supporting $56 trillion of credit), this has the potential to create a liquidity shock of epic proportions.

Source: FRB

However, given the stagnation in the growth of monetary aggregates (M2 and MZM), banks are not currently leveraging these new reserves. In fact, of the $850 billion added to the monetary base by the Fed, $733 billion has been re-deposited at the Fed by the money-centre banks rather than serving as reserves against new credit creation, suggesting that banks are not yet ready to initiate a new credit cycle. I have attached to charts to this email from the St. Louis Fed for illustrative purposes.

Source: FRB

In conclusion, the Fed and other central banks (notably the Bank of China) have certainly done everything in their power to create the elements necessary to catalyze another asset bubble powered by a new wave of credit creation by the money-centre banks. It remains to be seen whether markets will fall for the same trick a third time. Should the Fed succeed, and new bubbles form, investors would be wise to heed the lesson learned by participants in the market simulation cited above, and beware the trap of overconfidence. Not every investor can be quick enough to avoid the inevitable burst - are your tools up to the task?

Finally, it is the long term investor, he who most promotes the public interest, who will in practice come in for the most criticism, wherever investment funds are managed by committees, boards, or banks.

For it is the essence of his behaviour that he should be eccentric, unconventional, and rash in the eyes of average opinion.

If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.

Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

Disclaimer

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